CMG: ANOTHER IMPRESSIVE – ALBEIT IMPERFECT – QUARTER

Chipotle posted 1Q11 earnings after the market close. Comps once again were strong, and EPS came in slightly above expectations. Margin contraction, showing up for the first quarter since 4Q08, was what stood out most.

Management maintained its prior guidance of 135-145 new restaurant openings for 2011 and an effective tax rate of approximately 38.3%, however, full year comparable restaurant sales growth guidance was raised to “mid-single digit growth” from “low single digit growth” a couple of months ago.

Comparable-restaurant sales growth

As the chart below indicates, comparable restaurant sales grew 12.4% in 1Q11. This implies sequential growth in the two-year average trend of 110 basis-points. The comp was primarily driven by traffic during the quarter, with price adding 0.7%. Also contributing to the top-line growth was an online promotion ran in conjunction with the America’s Next Great Restaurant television show where customers who viewed a video promotion could visit Chipotle and receive two burritos for the price of one. In excess of a million customers visited Chipotle restaurants to redeem the offer. Management estimated that the promotion, running for two weeks, added nearly 1% to the overall comp in 1Q.

While management raised guidance from “low” to “mid” single digit growth for the year, 1Q comparable restaurant sales growth was so far in excess of guidance that the increase in annual guidance does not alter my view on where comps will likely be for the remainder of the year. Maintaining two-year average trends roughly flat with the trend in 1Q (excluding the online promotion) over the next three quarters implies a steep step-down in comparable restaurant sales growth over the remainder of the year.

However, it is worth noting that assuming these two-year average trends going forward could prove aggressive. The one-year comps required to such a trend would imply comparable restaurant sales growth of roughly 7% for the year. Furthermore, management struck a cautious tone on the earnings call when addressing the top line. Firstly, compares become progressively more difficult over the next three quarters, as management pointed out. Secondly, most of the effective 0.7% price increase that was on the menu in 1Q rolls off during 2Q. A price increase in the Pacific region stores, including California, of about 4.5% has brought menu prices there in line with the rest of the country. The Pacific region has the highest cost of business for CMG than any other region. Although prices have been increased in this market, management stressed that the company plans to wait until the third quarter to assess the impact of inflation and customer reactions to a possible price increase.

Inflationary headwinds starting to move the needle

Management maintained its cautious tone when transitioning to discussing costs. Food costs are obviously front-and-center for restaurant companies at present but, given CMG’s largely unlocked commodity basket, the topic is particularly pertinent for this stock. During the first quarter, food, beverage and packaging costs increased to 32% of sales (roughly 175 basis points year-over-year). Sequentially, food costs increased approximately 100 basis points, as a percentage of sales, and management estimates that about 60 basis points of this was due to higher tomato and produce costs due to the freeze in Mexico and Florida. The remaining 40 basis points relates to underlying inflation in items such as beef, chicken and avocados.

While the effects of the freeze in Mexico and Florida will fade as we roll through the year, other factors will “more than offset” this benefit in the second quarter, according to management. The most significant pressure that was highlighted was on avocados which, it was estimated, will add 50 to 60 basis points to food costs during 2Q due to a lower harvest than expected.

As the company considers its options on price in the third quarter, depending on how commodity costs impact margins over the summer months, it is important to note that the current growth in comparable restaurant sales is driven almost entirely by traffic. The extent to which a price increase adversely impacts traffic will obviously require the close attention of management. Clearly if management’s concerns around commodity costs are well-founded, the likeliness of a price increase seems to have heightened significantly since the 4Q10 earnings call.

One interesting aside is that corn prices, highlighted by CMG as a driver of meat prices during the 3Q10 earnings call, continue higher. During the last earnings call corn was trading at $7 per bushel, currently the grain is trading at $7.43 per bushel.

Labor cost uncertainty

Chipotle has generated plenty of headlines this year due to an ongoing federal investigation into the company’s hiring practices. Clearly I do not know how that will flush out, but the hiring and retraining of new employees, immigration experts, improved software systems to monitor documentation of workers, and other related expenses are not likely to help labor margins. It is encouraging to hear of new kitchen initiatives that will be margin accretive from an energy and labor perspective, but there is clearly some uncertainty surrounding the potential outcomes of the current investigation. Management was reluctant to even address a “worst-case scenario” outcome of the labor scandal.

Timing the 2011 Headwinds

During the 3Q10 earnings call, management stated that margins at CMG can be maintained “so long as we continue to see some comp growth – and we typically need something mid-single digit – generally with normal inflation”. 1Q11 saw margins roll decline year-over-year with a better-than-expected comparable sales number of +12.4%. With a far tougher compare in 2Q (8.7% in 2Q10 versus 4.3% in 1Q10), comps will likely slow significantly and – as management highlighted – commodity pressures will almost certainly be greater. I would expect 2Q food costs, as a percent of sales, to increase by 200-300 basis points versus the year prior.

With slowing comparable restaurant sales and increasing costs, the decision to pass on price to the customer is a momentous one. Management assumed a confident tone when assuring investors and analysts on the earnings call that Chipotle has pricing power, and that independent surveys support that view, but this is difficult to know until the price increase is implemented. The impact may vary from market to market and much could depend on the macro environment at the time. With gas prices and consumer confidence going in the wrong direction – up and down, respectively – it is certainly a risk. Following a couple of years of stellar performance and a seemingly teflon business model currently being awarded a 19.5x cash flow multiple by the street, CMG is playing a high-stakes game.

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